The NFT Marketplace: Philosophy, Legal Issues, and Risk

The NFT marketplace has exploded, and so has legal risk for its participants. Commercial entities and consumers alike see NFTs as marketing tools, investment strategies, and business drivers. All participants are trying to determine the rules for the road, philosophically as well as legally. Kyle-Beth Hilfer recently presented for PLI and the NYSBA Media Law Section, along with Christine Lawton, General Counsel of Wenew, Inc., and Aaron Krowne of Krowne Law and IBL. We discussed the wide variety of legal and business issues affecting the proliferation and dissemination of NFTs. This blog focuses on the philosophical underpinnings of the NFT’s ecosystem and associated legal issues.

Question: What are the biggest philosophical differences between web 2.0 and web 3.0?

Christine: In a lot of ways, it gets down to trust or distrust of centralized systems. Web 3.0 is about bypassing a lot of those centralized systems that maybe didn’t deserve trust in the first place. For example, certain tightly centralized systems, like real estate and financial markets, permit the architects of those systems to control information, decision-making and power. And yet, we saw those systems collapse. In decentralized systems, there aren’t those centralized gatekeepers. The result is a belief, whether correct or not, that there is more autonomy because there’s an opportunity to participate in decision-making. And there’s a sense that there’s more power associated with the “collective,” to make decisions. Because of that, it seems there’s more willingness to take personal risk.

Aaron: I’d reinforce the collaborative spirit and efforts. We’ve had open source projects before crypto that were revolutionary (e.g. Linux). This new “web 3.0” carries forward that ethos and creates new instruments in crypto, including NFTs, resulting in a new financial economy. There are all kinds of new abstract marketized relationships. It’s borderless too. People want that, and that creates a whole other area of legal and practical issues.

Kyle-Beth: Participants in the NFT marketplace believe they are creating something novel. We are seeing a freedom from hierarchy, from centralization, from geographic boundaries. The ecosystem is infused with a libertarian spirit that is creating new forms of community, and those communities, in turn, reflect the values of the creators and users. Everyone is creating something new, free from all the structures that we saw before. Of course, we are now struggling to figure out the parameters of legal issues that may constrain activity. The industry may eventually take steps to adopt its own standards. EIP-2981, for example, is a proposed resale royalty payment standard.

Question: What novel legal issues are we seeing?

Kyle-Beth: Of course, the intellectual property legal issues have been discussed in many sectors. What do you own? What are the limits on the NFT in terms of creating derivatives? And did the NFT creator even have the permissions needed to create the NFT? Is there new intellectual property associated with the NFT? The list goes on and on. My focus is on the interplay between those IP issues and marketing programs. How does that create new risk for brands? What do they own? What does the platform own? How are the marketing strategies around gamification bringing traditional lottery and gambling law concerns into play? And for those clients who want to stay on the right side of the law with regard to gamification, what adjustments do we have to make to their campaigns, their Official Rules, and how they communicate restrictions to the game participants? Then, there is the web 2.0’s popular influencer marketing. How will influence play out in the NFT ecosystem? What new instances ofconsumer confusion will emerge? I also see a devotion to doing good, as Christine has mentioned. As a result, there is a prominent charitable ethos. How will that work with existing commercial co-venture laws? And what about enforcement? If an NFT has a charitable condition, how will that be enforced in the secondary market? Finally, how do you prove that any terms of use were accepted by the purchase. How do traditional concepts of clear and conspicuous disclosure play out in a system that prides itself on anonymity, lack of fine print, and embedded risk-taking? It’s already under challenge in web 2.0; it’s going to be messy in web 3.0 until we figure out some rules of the road. Nonetheless, the standards and laws are still there.

Aaron: Securities law is another huge question. Are creators making securities or commodities? The securities laws are likely at play if there are continuing royalty streams, profit sharing or future benefits to be gleaned by the NFT owner. The royalties in particular should at least trigger an inquiry as to whether youhave to do a regulated offering (at least, in the U.S., and many other major jurisdictions). The platform may try to distance itself through direct offerings on the platform between creators/users. But this may fail to ward off broker/dealer concerns. And, are you in fact raising financing with NFT sales? The debate around these issues is active, but players should be really careful. The players want liquidity; they want to trade their NFT’s everywhere. But so far, there aren’t any NFT securities exchanges (though there are a few for “regular” tokens). So, it’s hard for NFT entrepreneurs to concede the securities law issues. In addition, the resale royalty rights are something created contractually and are different from a traditional royalty. Most NFT platforms are offering this as a new stream of monetization; they are going beyond the traditional “first sale” royalties as an incentive. Smart drafting helps, but it’s difficult if not impossible to clear up all kinds of risk. For the purchaser, does the NFT limit commercial vs non-commercial use, and what does that mean? Another legal issue concerns content protection. The first generation of NFT’s that came out didn’t “give” you anything in terms of the underlying art. That was novel, but had limited appeal. People became disgruntled quickly when they realized they didn’t own the underlying art (which sometimes vanished).If you want to parcel or transfer rights, you need some kind of protection on the underlying creative work. We are now seeing that crop up now in the next generation of NFTs. Another area where this is true is with NFTs that are twinned to physical product.

Christine: Another novel issue is the intersection of digital goods with the UCC. Does the UCC apply to the sale of NFTs? What’s the good here? What about the perfect tender rule? Can a customer reject the NFT if it is not as advertised? How is that measured in the sale of an NFT? Then there is the first sale doctrine—how do you moderate that in a digital space that allows an owner to make perfect copies and not give up, or exhaust, the original “good”? How does this not conflict with a copyright owner’s distribution rights; how do you navigate copyright distribution rights in the digital space if the first sale doctrine applies? A second huge problem is the communication and enforcement of contractual obligations in a largely anonymous space. On communication, there are issues of timing and placement. Timing-wise, we need to figure out how to articulate use restrictions during the purchase transaction, but there are few opportunities for the placement of disclosure. This is especially true with airdrops, giveaways, contests, and sweepstakes. This is true even on the big NFT platforms like Open Sea. If purchasers do not abide by terms and conditions, what recourse does the creator have? If a purchaser doesn’t live up to those terms, what can the creator, the aggrieved party, do? She can go after that user, but the anonymity of the blockchain can make that a difficult and costly enforcement proposition.

Question: What is the risk tolerance in web 3.0? What do you see with your clients?

Aaron: There’s a pretty high resistance to rules as part of the crypto ethos. That is the flip side of high risk tolerance. Of course, as the waves of innovation keep coming, the more responsible players are becoming the driving force and the standard-bearers. For now, however, in my practice, clients want to know the risk, but they also want to push the boundaries.

Christine: Yes, there’s a high risk tolerance, but I’ve been fortunate to work with people who are sober individuals who have been around the block. There is an ethos that we want to take care of each other in this space; a protective sensitivity. At the same time, many of the players create a sense of parallel universe, where they want the rules of our universe not to exist. But of course, they do, and so, we have to redirect that mindset.

Kyle-Beth: I also note the high risk tolerance among clients in this space, but I also see clients who want to profit but do so in a way that does not penalize others. The question will be how much that spirit of fairness and cooperation allows them to regulate themselves? Can all the players work together and protect one another, free from centralized control? That’s the goal. It seems fitting with the ecosystem’s philosophy. Still, we are starting to see litigation emerge based more on contractual issues. Time will tell whether regulators need to get involved.

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